A(n) (un)natural inclination

Economics like to assume that people are rational. Yet, humans are the most irrational being in the world. We have so many biases, assumptions and we are influenced so easily.

Remember in EP 3, I mentioned that digital economics is a closed loop system. In this closed loop system, we get to engineer incentives towards the targeted desired outcome.

How do we do this? Through behavioural economics. And this is the first underlying principle to manage an ecosystem. It takes into consideration the irrationality of people’s behaviour.

In this episode, we will dive into

What behavioural economics is
Why are we like that? Why are we so prone to influence?
How can we apply behavioural economics applied to token economics?

What is Behavioural Economics

Behavioural economics is a specific field of economics research. It studies the effects of social norms and individual psychology on economics decisions. In classical economics, we assume that everyone is logical. In behavioural economics, we study why people are illogical and why they behave like that.

For example, buying a 2 weeks worth of food during a pandemic is logical. But buying endless rolls of toilet paper?

Some possible answers:

“The thing about panic-buying is that it gives us a sense of control at a time when we’re lacking that,” says Deborah Small, a psychologist who studies consumer judgment and human decision-making at the University of Pennsylvania’s Wharton School of Business. She adds that things get harried when “people hear that other people are buying something, and they say, ‘Oh, I need that too.’ And it just spirals to this level where we have none.”

People compare and when everyone is doing it, they are more likely to do it too. It’s the herd mentality.
Some people don’t know what they want until they see it in context. Everything is relative, and if there is relatively less toilet paper than say noodles and rice, the irrational side is more interested in toilet paper.
To make people desire things, making that thing difficult to attain reduces the logical side. Toilet papers were literally out of stock, and attaining it is very difficult.

3 Themes

There are 3 themes to behavioural economics, heuristics, framing and market inefficiencies.

Heuristics

In Daniel Kahneman’s book, thinking fast and slow, he introduced 2 thinking systems in our head. System 1 thinks fast. System 2 thinks slow. Humans are not only illogical, but we are also super lazy. You would rather watch more mindless Netflix than solve a very difficult mathematics problem.

That’s not all your fault, really. Our brains are lazy and we like to take shortcuts. We like to take the path of least resistance. We like the easy way. That’s where System 1 comes in. System 1 learns from experience and it becomes a mental shortcut. Or a rule of thumb. You know how you can customise commands on Siri or Alexa? Same thing. Our brain does that. So we can conserve our energy when we need to think more.

That’s good right? Yeah, but no. We make 95% of our decisions with this shortcut tool, and the decisions does not consider other new information that is available.

Framing

The world is a very complicated place. Things are difficult to understand. How does internet work? How does emails work? What the hell is bitcoin? Why is the government doing what it is doing?

Well, this is why we have anecdotes, stories and stereotypes. It is easier to understand complicated things when it is simplified. They also become a mental filter for us to rely on understanding.

Think of Instagram filters. It is a set of fixed filters that is applied to our faces. But it doesn’t always work! Sometimes, we end up with strange glitches. Our brains, being lazy, apply these filters. Sometimes, glitch happens. And we make illogical decisions.

Market Inefficiencies

So what about heuristics and framing? Ultimately, it creates market inefficiencies. What are market inefficiencies? Pricing things wrongly, making illogical decisions, etc.

Why Study Behavioural Economics?

With economics, we like to predict things so we can make the best decisions. With classical economics, we assume that people are rational. Turns out, they are not. So with behavioural economics, we can predict people’s irrationality that defy economic theory.

Basically, we can predict better now.

How? There are a few ways, but a major way is called Prospect Theory. We evaluate options based on alternatives.

Let’s say I tell you that I will give you 100 followers on your LinkedIn. The value of that 100 followers depends on how many followers you currently have. 100 is the absolutely value. But 100 can be a lot psychologically, depending on the reference point. For someone with 500 followers, and it is nothing for someone with 10,000 followers. We also experience different sensitivity to the changes in followers. Adding 100 when you start with 500 feels better than adding 100 when you start with 10,000 followers. And we do love having more followers, who value and appreciate the work we do!

If you don’t remember anything, just remember that decisions are reference dependence. We need references to evaluate outcomes. And people don’t evaluate options equally. It depends on the changes, relative to the reference point in absolute value. People are happier when the difference is smaller than when the difference is too huge.

For example, 100 followers added to an account with 500 followers vs 10,000 followers.

Why are we like that? Why are we so prone to influence?

We have two levels of thinking. We have our rational mind that tells us, “No, I don’t need to buy another roll of toilet paper.” But we also have a more primitive, visceral, gut reaction that says, “Well, I better be safe than sorry. There will be no more toilet paper anymore.”

The herd instinct can also kick in, where people suspend judgement and start doing what everyone else is doing. So, if everyone else is panic-buying supplies, people follow the herd.

Heuristics influence our choices which are irrational and counter intuitive; we need help making better choices.

We are prone to influence in 6 ways:

Reciprocation: when someone does a favour for you, you are more likely to return the favour some day. For example, in crisis like this, China sends their doctors to Italy to help with the pandemic. I am certain this act will be reciprocated by Italy to China some day down the future.
Social Proof/Consensus: If you are in the blockchain space, are you sick of the word consensus? Consensus just means something the mass agrees to. It is also a form of social proof, because if everyone agrees to it, it is likely to be right. For example, if the WHO and government of major countries think that the virus requires a lockdown and pause on the economy, other countries are likely to follow suite and agree that it is the right course of action. I’m not saying it is irrational to do so, I’m just saying we can be easily influenced by the action that most people agree to do.
Authority: I notice this early on in my life. I’ve been to many events and conferences, where just because the speaker is an older caucasian dude talking about things, people just believe him. And when I stand up to correct the information, it always starts with looks of “who you think you are, young asian female.” But when coherent points and arguments are made, the audience starts to view me with more authority. We think with our fast thinking brain, called System 1. And we apply stereotypes that we previously had. It’s fine though, I think, as long as one is open to changes and be aware of the fast thinking that we have.
Liking: Believe or not, people like beautiful looking people and people that are similar to us. Model ****selling us something will influence us to purchase it more than some random ugly person on the street. We also like people who are similar to us, because familiarity is something we all love. That’s why nostalgia sells. We end up getting influenced easily this way.
Scarcity: We simply want something more just because we can’t have it. Why is Bitcoin so sought after? There will only be 21M Bitcoin in existence. Is there a real purpose for Bitcoin other than being a digital asset for investment? Maybe. Who knows. We are influenced and so captivated by the idea of scarcity, and that you can own something that someone else doesn’t have. Who is the best example of this? Supreme and everything that Supreme sells. They sell scarcity. And people are influenced to pay $100 for a brick.
Commitment & Consistency: Lastly, consistency and commitment. We are more influenced by someone consistent in their message. For example, Bernie Sanders and his message during his lifetime career of being a politician. Or commitment by Sanders as he campaigns the same message all the time. We are more influenced by people who are committed and consistent.

None of these make logical sense, but hey, we are not always logical, right.

How can we apply behavioural economics applied to token economics?

Firstly, it fits into Layer 2 of the economics design framework.

Layer 1 is the system architecture. That is the nerdy things and coded in algorithms or hard coded in the system. The framework is available as a research paper.

Layer 1 is limited, because it is based on classical economics and assumes rationality of people. We’ve already learnt that that fails. So we need Layer 2.

Layer 2 is a game design that embeds behavioural economics into the experience. Think of user experience plus gamification.

Gamified Systems

We can increase the probability of people’s irrational actions through design. For example, I have 3 options:

A: fruit basket for $15

B: candy bars for $10

C: fruit basket and candy bars for $15

What would you get? Most probably option C.

People rarely choose things in absolutely terms. We simply don’t have an internal value meter for what things are worth. It is easier when the item is being compared, to get its internal value.

Example: exchange tokens.

Exchange tokens gather its value when traders get to pay in fiat, crypto or the native exchange tokens. When they get a better deal with the exchange tokens, they are more likely to want to get the tokens, instead of selling it in the secondary market. E.g. BNB token

Nudge Theory

Nudge is a concept which proposes positive reinforcement and indirect suggestions as ways to influence the behavior and decision making of groups or individuals. Basically, influencing people’s “independent” actions towards the behaviour you want.

It’s kind of like Pavlov and his dogs. Ring the bell and the dog salivate. But it is more than just that. An example is Amsterdam’s Schiphol Airport attaching an image of a housefly into the men’s room urinals. Men would pee to aim at the housefly and cleanliness of the urinal went up. I guess men are not good at peeing.

Example: deflationary token

A simple example is deflationary tokens. Tokens have limited supply, and when demand soars, the price of tokens will increase. How can we nudge the demand? By reducing supply available like staking to be a validator or staking to earn interest on stakes. The behaviour you want is to reduce available supply, so as to increase prices. So you can influence the behaviour by having a better trade-off: earning interest on tokens staked.

6 Influence Methods

Reciprocation: By adding value first, before extracting value. For example, Crypto.com provides value-add like free netflix, free amazon prime and free spotify when you sign up with their cards.
Social Proof/Consensus: The simplest example would be Augur, the online betting platform. But that is their business model, so it doesn’t count. Why is Bitcoin so valuable? Almost all crypto-people I know have assets in Bitcoin. The social proof is strong. When prices of Bitcoin fell on 16 Mar 2020, instead of liquidating more, social media was asking everyone to purchase more, since prices were so low. That consensus brought prices of BTC up again in 24h.
Authority: Authority comes from the background of the founders, their experience, educational background and street cred in the space. This is most evident in blockchain projects by academic professors like Silvio Micali, who founded Algorand.
Liking: I still find this funny, but in Asia, you see companies hiring pretty females to model for their crypto-projects. And according to plenty of my male friends in the space, these girls do a great job at influencing males to sign up for their projects.
Scarcity: We simply want something more just because we can’t have it. Following Bitcoin’s path of limited supply, every other project has a capped supply of tokens to induce scarcity.
Commitment & Consistency: When Bitcoin’s price fell on 16 Mar, the community was selling bitcoin hard on twitter and reddit. It’s interesting because these people have quite some BTC in their portfolio, and they need to pump up the prices and continue the faith that BTC is worth something. Whatever it is, they are consistent in their message and truly committed in their shilling.

Conclusion

In conclusion, many design of these crypto systems fail even with beautiful mathematical formula is that they miss out behavioral economics.

Economics design of the crypto ecosystems are in 2 layers.

Layer 1 is the system architecture. That is the nerdy things and coded in algorithms or hard coded in the system. For example, matching algorithms, resolution mechanisms and monetary policy.

Layer 2 is a game design that embeds behavioural economics into the experience. That is user psychology plus gamification.

If designing an ecosystem is like making creme brûlée, behavioural economics is using the blowtorch to caramalise the sugar to light golden brown. It’s a very crucial and important step!

3 Discussion Takeaways Worth Pondering

Do you think designers need to abide by some regulations to ensure the morality of how systems are designed? It could go out of hand to influence people’s decisions. This is evident in the countless of scams around.
Isn’t behavioral economics a depressing view of human nature?
How can we use good design for good purposes? For example, using nudge theory to encourage good behaviours. We collect data of someone’s health status, and reward them with tokens when they attain certain healthy metrics. That’s a positive use of nudge theory.

It’s A Propunsity – Behavioural Economics